FEDERALISM AND CAPITAL MARKETS IN CANADA AND THE US: FINANCING INFRASTRUCTURE IN THE WAKE OF HURRICANE KATRINA W. Bartley Hildreth Hurricane Katrina was much more than a natural disaster, it also left New Orleans and the Gulf Coast of the United States financially devastated. The rebuilding effort will take place on the ground, coordinated largely by the state and federal governments and financed in capital markets. “Markets can supplement federalism,” writes Bart Hildreth, a visiting Fulbright scholar at McGill University. “A key advantage of debt markets is that these competitive, risk-bearing institutions are less prone to accept questionable projects and financial plans than are politicians up the federal hierarchy,” he says. Hildreth examines the financial relationship and programs of the federal governments in the US and Canada with the sub-national governments at the state/provincial and municipal levels, and concludes each country could learn from the other. “Citizens in both countries were left in awe of the sudden disintegration of New Orleans and its infrastructure,” he concludes. “As with infrastructure questions elsewhere, the solution is likely to be found in a combination of federalism and capital markets.” Au-delà de la catastrophe naturelle qu’il a causée, l’ouragan Katrina a financièrement dévasté La Nouvelle-Orléans et la côte du golfe du Mexique. L’effort de reconstruction, qui sera coordonné par les gouvernements de l’État et du pays, sera toutefois financé grâce aux marchés de capitaux. « Ces marchés peuvent compléter le fédéralisme », écrit Bartley Hildreth, professeur invité à la chaire Fulbright de l’Université McGill. L’un des avantages clés des marchés de la dette réside dans la circonspection de ces institutions de risque, moins susceptibles de souscrire à des plans et des projets douteux que le sont les politiciens du sommet de la hiérarchie fédérale. L’auteur examine les programmes et les relations financières qui unissent les gouvernements fédéraux américains et canadiens aux « gouvernement sousnationaux », estimant que nos deux pays pourraient apprendre l’un de l’autre. « Les citoyens de part et d’autre de notre frontière ont été bouleversés par la désintégration de La Nouvelle-Orléans et de ses infrastructures, conclut-il. Et comme partout ailleurs où des problèmes d’infrastructure se sont posés, la solution nécessitera vraisemblablement une combinaison de fédéralisme et de marchés financiers. »
H
urricane Katrina confirmed the power of nature to destroy the built environment. This built environment includes the capital assets of government, especially the infrastructure items of roads and highways; water and sewer systems; bridges; canals, waterways and levee systems; educational facilities; and other government buildings. Public infrastructure plays a key role in economic growth and productivity. New Orleans is a vivid reminder
of what happens to a community when its public infrastructure disintegrates. This devastating event helps focus our attention on fiscal federalism, or the financial relationships between central and sub-national governments, and among those subnational governments. By sub-national government, I mean Canadian provinces and their municipalities and, in the US, the states and their local governments. POLICY OPTIONS DECEMBER 2005 - JANUARY 2006
39
W. Bartley Hildreth Federalism carries a bias for decentralization, and that is consistent with theory and practice. However, efficiency is not the economic principle that comes to mind when we think about government budget decisions. A major policy question for both countries is the extent to which higher levels of government respond to local infrastructure needs. As we see on the American Gulf Coast, there
any other in North America, the mismatch between needs and funding is not confined to a disaster zone. I want to link these two areas. First, I will clarify key differences between US and Canadian sub-national capital market practices. Then, I will examine the role of market and hierarchy in dealing with the infrastructure crisis of a disaster zone. Hierarchy and markets have a
price tag for the clean-up and reconstruction of New Orleans (and other devastated areas of the Gulf Coast).
M
arkets can supplement federalism. A key advantage of debt markets is that these competitive, riskbearing institutions are less prone to accept questionable projects and weak financial plans than are politicians up the federal hierarchy. A The loss of the most recent “battle of New Orleans” raises the corollary that most politicians forget is that markets stark question of how a community without a tax base can the strong and penalpay for its come-back through market mechanisms. The quick reward ize the weak. They are not a answer is that governments have never relied solely upon redistributive mechanism. markets, so why start now? Since the early 1990s, Canadian provincial and role, both in the New Orleans stress municipal governments have changed is a desire to get others up the federal case and in the normal course of govtheir capital market behaviour. That hierarchy to bail-out local governments. ernment finance in both countries. decade started with aggressive debt In contrast to hierarchy, markets accumulation to offset balance sheet are efficient mechanisms for allocating deficits, debt placement with internal resources. In terms of capital markets, nfrastructure is more than longpension accounts, and extensive forself-interested borrowers and lenders lived physical assets (such as roads, eign borrowing for both general govapproach each other with opposite bridges, water systems, schools and airernment and hydro-electric operations. goals. The borrower wants money at ports) owned by governments — Net debt reduction is the current the lowest cost, while the lender wants although that is the standard definipractice along with a winding down of the highest possible return. Institutions tion. As recent events (from 9/11 to private placement in government penand rules help bring these two diverNew Orleans) illustrate, critical infrasion accounts, the deregulation of gent positions together into a completstructure extends beyond that owned hydro-enterprises, and a crowded (taxed market transaction. by government to include privately able) domestic capital market. owned energy and communications Moreover, there is a renewed focus on systems essential for a functioning ub-national governments in the the need for infrastructure financing, society. United States and Canada have of which the federal Infrastructure In 2001, the C.D. Howe Institute long enjoyed the power to enter capital Canada program is a good example. published a study advocating a broad markets to finance capital assets and, in Canadian provincial and municipal definition of infrastructure to include some cases, to finance operating governments continue to use direct “the physical and human capital that deficits. A key policy question is how and guaranteed bonds (both, in broadly facilities production, condo sub-national governments navigate essence, general obligation bonds). sumption, and further investment.” the market place to obtain money at an In contrast to Canadian changes Based on a more traditional definiacceptable price within the confines of over the past decade, there has been tion, research conducted for the a federal form of government? little change in the basic US trends Infrastructure Canada program calcuMoreover, the loss of the most during the same period. American lates that the public infrastructure gaps recent “battle of New Orleans” raises state and local governments continue in Canada and the US are comparable the stark question of how a communito issue what are termed “municipal when adjusted by population. ty without a tax base can pay for its securities” — all in their own domestic In both countries, higher-level govcome-back through market mechatax-exempt capital market. ernments are looked upon as the prenisms. The quick answer is that govUS federal tax laws specify that the ferred funding source for locally ernments have never relied solely interest on the obligations of a state, a conceived projects, and the national upon markets, so why start now? territory, a possession of the US or any governments of both countries have This article examines the role that political jurisdiction of any of the foreresponded with limited programs. hierarchy and markets have on the going or the District of Columbia is not Getting others to pay for one’s needs provision of infrastructure in our two subject to federal income taxes as part and wants is an ageless desire. A current countries. While New Orleans is expeof gross income. This definition permits example concerns who will pick up the riencing an infrastructure crisis unlike
I
S
40
OPTIONS POLITIQUES DÉCEMBRE 2005 - JANVIER 2006
Federalism and capital markets in Canada and the US
US Senate
City under water: New Orleans and the Gulf Coast were devastated by Hurricanes Katrina and Rita. The response to the emergency, and the re-building, must be co-ordinated and financed by the three levels of government. It is a test for the American federal system, as well as for capital markets. Markets, writes Bart Hildreth, are less inclined than government is to finance dubious projects.
an ever-increasing number of sub-state “political jurisdictions” (including limited purpose districts) to enjoy the benefit of issuing tax-exempt debt Currently, there are over $2 trillion in municipal securities outstanding. Other borrowers (namely, the US Treasury and corporate borrowers) issue debt where bondholder interest is taxable. The federal government foregoes about $35 billion a year in the taxes that would be due on interest earned. This loss of revenue, termed a tax expenditure, is a major feature of American fiscal federalism. This loan subsidy program was overlooked earlier in October by the Torontobased Institute for Competitiveness and Prosperity in its report entitled “Fixing Fiscal Federalism.” That report sought to compare US and Canadian public investment spending, but somehow missed this most significant element of public investment practices in the US.
A
merican governments are not big users of general obligation bonds that carry a legal pledge of the full faith and credit taxing power. In fact, only 20 percent of the debt volume each year carries this broad repayment pledge. The other 80 percent represents bonds that are secured by a legal pledge of a dedicated revenue stream — thereby earning the “revenue” bond label. Examples of pledged revenues include net receipts of public enterprise operations; expected receipts from dedicated local taxes (such as tourism-related taxes); agreements to pay lease obligations sufficient to retire the debt on a building, facility or major piece of equipment (with or without a mortgage on the property); and obligations secured by some other type of contractual agreement. Revenue bonds require more investor scrutiny, since the collateral is tied to specific, but estimated, revenue
flows. There is no legal recourse to the general taxpayers. In Canada, sub-national debt is direct and unconditional — meaning they are “general obligation” bonds in American terminology. Traditionally, even provincial enterprises, such as the capital-intensive hydro-electric operations, get to pledge the general credit of the controlling province instead of borrowing on its own credit quality. How does the bond process work? Well, issuers sell their debt in an aggregate amount to a wholesale purchaser (typically an investment banking group), which then remarkets the bonds in smaller denominations to the ultimate investors. Canadian provincial and municipal governments negotiate the price with the fiscal agent. In America, a similar practice is followed for nearly all revenue bonds due to their unique “stories,” but “plain vanilla” general obligation bonds usually require an auction. POLICY OPTIONS DECEMBER 2005 - JANUARY 2006
41
W. Bartley Hildreth for US infrastructure development. with protection for the life of the Who invests in these bonds? Most bond. Bond insurance companies, in of the US municipal bonds are held essence, rent out their triple-A credit. directly by households or in retail-trado, what is Canada doing on the The bond insurer is betting that the ed financial instruments. I have not infrastructure front? The Canadian debt will not go in default. Bond rating confirmed the details for Canada, but government’s recent infrastructure fundagencies, such as Moody’s Investors there are differences regarding at least ing programs — under the Infrastructure Service, subject these bond insurers to two classes of institutional investors. Canada banner — represent an awarestrict depression-scenario stress tests to First, pension plans in America ness of the sub-national infrastructure make sure that the bond insurer can (including the social security trust fund) problem. Despite this start, it is unlikely withstand multiple defaults. have no economic incentive to invest in that existing hierarchical programs will Of the bonds from the disaster lower-yielding, tax-exempt securities. relieve local communities of the need to zone that Moody’s had immediately Thus far, legislative proposals to create access capital markets. placed on credit watch following the an incentive program have failed. At least one Canadian financial firm hurricane, Merrill Lynch estimated In contrast, the Canada Pension (TD Bank Financial Group) dismisses a that bond insurance covered 69 perPlan, for example, offers a pool of patient Canadian tax-exempt bond program as a cent of the 51 bond ratings (totalling capital that has been used to invest in viable option for addressing the infra$9.4 billion). In the case of New provincial bonds (since they are priced structure gap. The firm’s 2004 report Orleans, most of the public infrastruchigher than the federal government’s highlights three primary concerns; ture bonds carry bond insurance. bonds). Some of the CPP’s holdings are namely, the loss of federal government placed there by quota, and others revenue, disproportionate beneare purchased on the open marfits accruing to taxpayers facing Federal grant actions carry strings, ket. Of course, it is best to have an than average tax rates whether the grants are for 4R or to higher arms-length arrangement in (thereby a regressive outcome), meet new standards. A few order to avoid market-making and the money saved by the submanipulation, as happened with national government borrower lawmakers from other parts of the some provincial pension plans in paying a lower interest rate may country have said that since the past. not equal the federal loss of revLouisiana, in general, and New A second type of institutionenue (meaning the fiscal agent, Orleans, in particular, has a colourful and others, pocket the differal investor is the financial intermediary that fosters home history of political and legal misdeeds, ence). Moreover, the only test of ownership. In this country, the a tax-exempt bond in Canada — there is a need for more Canada Mortgage and Housing Ontario Opportunity Bond accountability for the federal dollars. the Corporation (CMHC) is a signifiprogram, which provided an From the very beginning of the cant presence in the sub-national exemption only from Ontario bond market. The similar governincome taxation — was termifederal dollar response, the federal ment-sponsored corporations in and state governments have assigned nated after only one bond sale. America — Fannie Mae and are needed about this auditors to keep account of the funds. Details Freddie Mac — have no incentive financial experiment to judge its to invest in tax-exempt securities, effectiveness. unless it is for social purposes. It is for that I now want to address hierarchy and The bottom line is that American reason that Freddie Mac has announced market options for dealing with the infrastate and local governments borrow that it will buy up to $1 billion of housing structure crisis in a disaster zone. Most of money in the domestic tax-exempt bonds from Mississippi and Louisiana, as these comments address the situation facmarket at a cost of capital that since a way to foster the rebuilding of the housing one local government in particular, January 2000 has averaged 40 basis ing stock in those states. the City of New Orleans/Parish of Orleans points below comparable length securiDefault on a sub-national govern(it is one and the same). But these comties issued by the US Treasury in the taxment debt instrument is rare. A bankments generally apply to other sub-state able market. In contrast, over the same ruptcy filing covering the entire political political jurisdictions, including city, period, based on data provided by jurisdiction is even less frequent. counties (or parishes), independent Scotia Capital, Canadian provincial and school districts, and other special authormunicipal bonds have yields about 55 ities and districts. basis points above Canadian Treasury et, in the US, 50 percent of the The New Orleans case illustrates the instruments, because all debt instrumunicipal bond volume carries fragmented nature of local governments ments generate taxable interest. This bond insurance as an additional credit in America. In New Orleans Parish, politdifference in quality spread constitutes support. The debt issuer pays an upical jurisdictions have an estimated $2.7 a significant fiscal federalism advantage front premium to provide investors
S
Y 42
OPTIONS POLITIQUES DÉCEMBRE 2005 - JANVIER 2006
Federalism and capital markets in Canada and the US From the very beginning of the federIt is unclear if President Bush can use billion in debt obligations outstanding, al dollar response, the federal and this account to cover the cost of repairing with most of it not general obligation state governments have assigned audithe levees above the existing standard — debt but rather Revenue bonds backed by tors to keep account of the funds. a category 3 hurricane. To build New a dedicated revenue source. In addition, In terms of “decreased revenues,” Orleans’ levees to a higher standard will there is about $7.5 billion State of there is an existing FEMA structure for require a new congressional appropriaLouisiana debt outstanding. community disaster loans. The president tion of an estimated $3.5 billion. That My framework is that a distressed is authorized to make loans to any local decision is likely to be the subject of city must deal with (1) increased government that may suffer a substantial much debate among newly concerned expenditures, (2) decreased revenues loss of tax or other revenues as a result of fiscal conservatives in Congress, but the or the loss of the tax base, and (3) a a major disaster, and has demonstrated a early expectation is that the money will portfolio of debt obligations. need for financial assistance in order to be provided by Congress. Moreover, the I assume the subject city has cut its budget, as New Orleans has done and Markets can supplement federalism. A key advantage of debt will likely continue to do. markets is that these competitive, risk-bearing institutions are less Moreover, I assume the city will not raise the tax prone to accept questionable projects and weak financial plans rate to preserve the pre- than are politicians up the federalism hierarchy. A corollary that disaster revenue flow. most politicians forget is that markets reward the strong and Remember the basic tax penalize the weak. It is not a redistributive mechanism. formula: tax rate X tax base = the amount of perform its governmental function. In its early reports from the independent taxes collected (assuming no delinKatrina legislation, which passed Conforensic engineering investigations quencies). For example, unless the gress on October 7, Congress funded a organized by the National Science rules are changed in Louisiana, tax Katrina loan program, but in a move that Foundation suggest that the Corps of rates will have to go up on the remaininfuriated Gulf State public officials, ConEngineers allowed the flood walls to be ing (smaller) tax base in order to cover gress removed the traditional presidential built without driving the anchors, or the existing debt. option, frequently used, to forgive such steel pilings, down into solid ground. loans. Efforts by regional interests have Instead, the pilings stopped at a shallow n terms of “increased expenditures,” been unsuccessful thus far in restoring the level where there is weak soil. I suspect the Federal Emergency Management president’s discretion for Katrina loans. that if this finding holds up, the burden Agency has an existing program allowIt is not uncommon for governwill be on the federal government to coring the president to make contributions ments to borrow money to get over a rect this Corps of Engineers design flaw, to repair, restore, reconstruct or replace liquidity problem by, for example, borinstead of shifting the blame or financial (4R) a damaged public or nonprofit rowing in advance of the receipt of tax burden to the state or local government. facility, and for associated expenses. collections. But, the problem caused by There is little need for the state governThis grant program covers items from a disaster is different — the tax base is ment to make contributions for 4R work, debris removal to overtime of police and “underwater,” both in financial and given the FEMA role. However, if the fire services. The federal share of assisphysical terms. Borrowing against a preState of Louisiana has to participate in tance is at least 75 percent, but the presestablished line of credit is possible. The the funding of these programs, it will ident can expand that percentage. State of Louisiana is doing that. have to borrow the money. Debate now centers on the period for Moreover, one of the City of New Local governments also have the full funding, with an early end to it preOrleans investment banking instituoption of going to the market, but the ferred by those concerned about the tions has provided a line of credit that market may not be receptive at a price budget impact. Devastated areas, of even the firm says would not be possithat the government can afford. course, prefer a period of full coverage, ble if it used normal credit guidelines. Federal grant actions carry strings, perhaps up to a year. Mississippi created a state loan whether the grants are for 4R or to The President’s discretion is limited pool for its local governments to access meet new standards. A few lawmakers by the amount of funds appropriated by for liquidity and capital projects related from other parts of the country have Congress. In late October, it was reportto Katrina. Louisiana is in the process said that since Louisiana, in general, ed that FEMA has only spent or signed of setting up a similar program. and New Orleans, in particular, has a contracts for a quarter of the $62.3 bilCongress has provided several colourful history of political and legal lion in disaster aid that was rushed avenues to deal with the need for housing misdeeds, there is a need for more through Congress within 10 days of the and business redevelopment. I will not go accountability for the federal dollars. hurricane.
I
POLICY OPTIONS DECEMBER 2005 - JANUARY 2006
43
W. Bartley Hildreth into all of the details, but suffice it to say there are calls for additional programs. One model is the Liberty Bond program authorized for New York City’s Ground Zero recovery zone. This program waived certain rules that limit the way private firms can access the municipal securities market. For example, the Liberty Bond program lifted the state volume cap, exempted the bonds from the Alternative Minimum Tax, and permitted the bonds to be purchased by banks under special
country — has announced that it will buy up to $1 billion of new housing bonds from Louisiana and Mississippi, at below market rates, for the next two years. Merrill Lynch anticipates that the Freddie Mac program will “probably absorb the total new supply” of housing bonds from those states. If the federal government does not guarantee local debt, what can it do to help local governments such as New Orleans? Congress is likely to allow state
In that vein, President Bush has proposed a “Gulf opportunity zone,” but the details are sketchy. Assuming Congress provides municipal bond issuers a second advanced refunding, then the state and its local governments can seek to push off the repayment into out-years and free up near-term resources. Congress is likely to provide this flexibility.
E
ighty percent of state and local government In addition, Freddie Mac — a large financial intermediary set bonds are revenue bonds. up by the national government to provide private mortgage This means that the general loan liquidity across the country — has announced that it will taxing power does not serve as collateral. Rather, a dedibuy up to $1 billion of new housing bonds from Louisiana cated stream of resources is and Mississippi, at below market rates, for the next two years. all that supports the bonds. Merrill Lynch anticipates that the Freddie Mac program will For example, New Orleans Convention “probably absorb the total new supply” of housing bonds Facility bonds are backed by from those states. an excise tax on hotel occuand local governments in the disaster pancy and restaurant sales. When terms (the so-called bank qualified status). zone to refinance debt — a change in there is no money flowing from those These provisions expanded the market for sub-national debt rules. This is termed an sources, then the bonds are at risk. Liberty Bonds, thereby permitting affect“advanced refund,” because the old debt While these bonds may not have ed firms to borrow at lower cost than they remains outstanding, with the new debt defaulted on the timely payment of might otherwise have to pay. These bonds proceeds used to buy risk-free US principal and interest, most are likely to are not backed by the government. For Treasury securities that will mature at the have triggered an “event of default” by this and other reasons, these types of yearly dates when the old debt’s principal not abiding by some condition of the bonds are privately placed and not sold to and interest payments are due. There is a borrowing agreement. This is termed a retail investors. limit of one advance refunding per govtechnical default instead of a financial ernmental purpose bond issue, because default, and it can have a negative influnother set of programs targets the of the loss of federal taxes on the interest ence on secondary prices paid by housing crisis through the stimupayments received by the investors of investors and the cost of future borrowlation of single-family and multi(now) two bond issues that are outstanding by the government itself. family mortgages. FEMA has a ing for the same capital project. After One option is bankruptcy. Under transitional housing program that 9/11, Congress granted New York City the US Constitution, the Congress sets includes rental assistance and mobile this second refunding, and it is expected bankruptcy law. There is a special sechomes. Under long standing tax law, to be used for the Gulf zone too. The tax tion (chapter 9) devoted to municipal state and local governments can estabexpenditure “cost” to the federal governbankruptcy. The key difference lish mortgage loan programs that are ment is manageable, and it offers a marbetween municipal and business or funded by housing bond proceeds and ket-based solution instead of a federal individual bankruptcy is that creditors secured by mortgage repayments. The grant of money. cannot force a municipality into banklocal government agency is not the One possibility is the creation of a ruptcy. Municipal bankruptcy must be ultimate obligor (payer) on these housfederal recovery agency like the voluntarily entered into, and under ing bonds, but instead, serves as the Tennessee Valley Authority. As one of federal law, the respective state govconduit for these entities to access the FDR’s New Deal agencies, the TVA ernment must first permit the local municipal securities market. For the brought electricity and economic government to file for bankruptcy. disaster zone, Congress has eased up development to the southern State and local governments may on some of the rules. Appalachian Mountain area. It has had seek to borrow money, but they will likeIn addition, Freddie Mac — a large a significant impact on the region’s ly face new credit criteria. Of course, financial intermediary set up by the economy. Today, it is the largest public those governments affected will have to national government to provide pripower company in the US. demonstrate the ability to repay the debt. vate mortgage loan liquidity across the
A
44
OPTIONS POLITIQUES DÉCEMBRE 2005 - JANVIER 2006
Federalism and capital markets in Canada and the US But, there may be a market-wide change in the works. As noted by a recent Merrill Lynch analyst, bond-rating agencies may need to revise their credit criteria to incorporate the probability of a natural disaster striking a community. One logical result would be the requirement of a contingency reserve. This would not be welcomed by government borrowers.
T
he private economy rests upon public infrastructure, and it is this infrastructure that must be protected from nature and other risks, such as terrorism. How a federal structure fosters the provision of the public infrastructure is an important policy issue. Hierarchical programs, such as Infrastructure Canada, are unlikely to solve the infrastructure deficiency. Neither is the answer to turn completely to the credit markets. While the decentralized credit market orientation in the US has not solved its infrastructure gap, the discipline of the marketplace supplements hard
constitutional rules and soft management polices. Both the Canadian and US constitutions are silent on the role of municipalities and other local governments. Each province retains a strong hand on the affairs of its municipalities, even extending in many cases to a mandatory review of local tax and debt plans. In such a framework, any local financial problem is bound to be considered a problem of the province. In America, cities borrow on their own credit, meaning that the bond investors have no recourse to the state treasury. Since most municipal debt is in the form of revenue bonds, neither do the investors have recourse to the general property tax. Bond insurance has further separated the investor from the plight of the underlying city credit, much less from the state, which created the city in the first place. Unlike the stability of constitutions, capital markets are fluid, with the cost of capital changing literally by the minute. In America, globalization trends, fair
trade requirements and the possibility of fundamental federal tax reform are risks to the domestic tax-exempt market for American state and local governments. Therefore, Americans can learn from the Canadian taxable market experience. Canadians, in turn, can learn about the unique American tax-exempt market and the innovative power of this decentralized market-based approach to infrastructure finance. Citizens in both countries are left in awe of the sudden disintegration of New Orleans and its infrastructure. As with infrastructure questions elsewhere, the solution is likely to be found in a combination of federalism and capital markets. W. Bartley Hildreth, Regents Distinguished Professor of Public Finance at Wichita State University, is the visiting Fulbright Research Chair at the McGill Institute for the Study of Canada. This article is adapted from his Fulbright Lecture at McGill University on October 28, 2005.
[email protected]
POLICY OPTIONS DECEMBER 2005 - JANUARY 2006
45
